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Friday, 25 April 2014

Life Insurance and the 831(b) Captive Insurance Company - Wait For The Test Case Before Signing Up

Dyman
Associates Insurance Group of Companies

There is an old saying about life insurance: “Life insurance
isn’t bought, it is sold.” The public doesn’t exactly clamor to buy life
insurance, and if you don’t believe me then just try to find a life insurance
store at pretty much any major retail mall. Instead, life insurance agent and
financial planners (and increasingly accountants and attorneys) look for suitable
prospects and opportunities to sell life insurance to those with a perceived
need.

There is no doubt that while the public doesn’t really think
much about buying life insurance, they have a need for it. Life insurance
serves the purpose of funding the family’s continuation at death, and prevents
the financial shock from the loss of the family’s main provider.

Life
insurance is also sold as a tax shelter of sorts. Because the investment growth on the
cash value of a life insurance policy is not taxed, and in fact may never be
taxed, life insurance can sometimes be a very efficient investment. (And
sometimes not — eventually, the cost of insurance which increases dramatically
with age can significantly eat away at investment returns, and more often than
not the investment returns somehow never quite match the pollyannaish
predictions of the illustrations shown to prospective buyers — those
illustrations with unrealistic financial projections being known in the
industry as “liar ledgers”).

The problem with life insurance as a tax shelter is that
typically it must be purchased with post-tax dollars. Historical attempts by
creative attorneys and financial advisers to manipulate various tax-free
strategies to encompass a life insurance policy have nearly all ended in
disaster: VEBAs, 412(i) plans, and 419A(f)(6) plans all ended with the
taxpayers often paying more tax in the end than if they had done nothing in the
first place, and lawsuits against advisers for professional negligence nearly
hit the epidemic point.

For somewhat obvious reasons, the IRS has typically gone
after arrangements that were pitched to clients that they could purchase a
large amount of life insurance with pre-tax dollars like a heat-seeking
missile. Yet, advisers persist in trying to wed life insurance to things that
it shouldn’t be hitched to, so as to obtain the result of a pre-tax purchase of
life insurance — and big commissions to the advisers, who if in good with their
insurance company, might make upwards of 40% of the first-year’s premiums paid
in on a Universal Life policy, and upwards of 80% on a Whole Life policy (they
almost never disclose these commissions to their clients, of course).

The latest attempt to wed life insurance to something that
will result in a pre-tax purchase of life insurance is that involving smallish
captive insurance companies. These companies make the 831(b) election so that
they are not taxed on their premium income, with the result that the underlying
company can quite lawfully pay some reasonable amount of premiums to the captive
and take a current-year deduction for it, but the captive does not pick up the
premiums received as income.

From a tax standpoint, the benefits of an 831(b) captive are
not that great — most of the money should be used to pay claims if the
actuarial calculations of the premiums are anything like close, and then the
balance of the money is subject to capital gains taxes when the company is
liquidated. In the meantime, an 831(b) captive is not allowed to deduct all, or
even most, of its operating costs.

Plus — and here is where life insurance re-enters the picture
— an 831(b) captive is internally taxed annually on its investment income,
which further eats into the tax efficiency of the captive. But what if the
captive could purchase life insurance — which grows tax-free — and thus avoid
the tax on its investment income? Welcome to the life insurance tax shelterdu jour.

There are now tax shelter promoters out there (many of them
the same ones who sold VEBAs, 412(i), and 419A(f)(6) plans in past years) actively
marketing and selling 831(b) companies as a conduit to purchase life insurance
with pre-tax dollars. Sometimes they try to disguise the transaction by having
the captive do a split-dollar transfer to a trust that buys the life insurance,
or having the captive invest in a preferred share of an LLC that buys the life
insurance. This is just putting lipstick on the pig. Others just tell their
clients to purchase life insurance directly inside the captive.

The truth is that it is probably fine for a mature captive,
meaning one that has been around for some years and has large reserves and
surplus, to use a small amount of its investable assets to purchase a key-man
policy, or maybe invest in life settlements or the like.

But this is not how the 831(b) captives are being sold;
instead, clients are being shown illustrations where the life insurance is
being purchased soon after the first premiums are paid to the captive (the
advisers want their commissions now, not later), and the efficiency of the
captive is being measured not in its effectiveness as a risk-management tool
(it’s proper purpose) but rather as an investment and estate planning tool (the
improper tax shelter purpose).

In reviewing these transactions, the presence of the 831(b)
captive is simply a sham. Premiums in these deals are rarely calculated based
on anything like real-world risks, but the promoters are making a determination
of how big of a deduction the client wants, and then “backing in” the premium
amounts with the help of actuaries who will testify that a $500,000 premium for
$2 million worth of terrorism insurance for a business in Lenexa, Kansas, is
reasonable, and, oh, also that the world is flat, water is dry, hot is cold,
and the sun comes up in the West.

This issue came up at the Spring Meeting of the Business Law
Section of the American Bar Association, where theCommittee on Captive Insurance
Companies(of which I am the outgoing Chair), had a panel presentation on Tax &
Regulatory Issues With Captive Insurance Companies. [The opinions expressed
herein are my own opinions, and are not anything like the opinions of the ABA
or the Committee.]

The panel featured Prof. Beckett Cantley of John Marshal Law
School in Atlanta, who discussed the fact that the IRS is taking a hard look at
831(b) captives that have purchased life insurance, and seem to be following
their exact same avenues of attack that finally took down abusive VEBAs,
412(i), 419A(f)(6), and other abusive plans that offered pre-tax life
insurance. Namely, the IRS is now conducting various promoter audits to obtain
the client lists of the insurance managers whose 831(b) captives are involved
with life insurance, as a possible predicate to making the purchase of life
insurance within a captive a “listed transaction”, i.e., a presumed tax shelter
that carries onerous reporting requirements and possibly very significant
penalties.

Professor Cantley also spoke at some length about the
technical issues about why the IRS would be absolutely right in taking down
831(b) companies with significant amounts of life insurance, but instead of me
paraphrasing him, it is probably better to just read his excellent article on
the subject: Cantley, Beckett G., Repeat as Necessary: Historical IRS Policy
Weapons to Combat Conduit Captive Insurance Company Deductible Purchases of
Life Insurance (February 2013). U. C. Davis Business Law Journal, Vol. 13,
2013. Available at SSRN:http://ssrn.com/abstract=2315868

And Professor Cantley is nothing like the only voice in the
wilderness on this issue: Various other prominent captive tax attorneys have
indicated that having an 831(b) captive be structured to invest significant
assets in a life insurance policy is probably a pretty bad idea, and
off-the-record statements from IRS and Treasury officials (not to mention the
ongoing promoter audits) show that this is an area of intense interest, if not
concern.

As well it should be. By identifying 831(b) companies that have purchased
significant amounts of life insurance, whether directly or through split-dollar
arrangements, etc., the IRS can more readily identifyen massecaptive arrangements that are
technically defective insofar as they cover risk that barely exist and have
premium amounts for certain policies that are not even in the time zone as
reality. The potential return of unpaid taxes to the IRS would be tremendous,
and such would be very cost-effective.

While there are many highly-credentialed and experienced
experts in taxation that warn against an 831(b) being used as a conduit to
purchase life insurance, there is pretty much nobody outside those selling the
strategy who think that it is anything like a good idea. Those who do sell
831(b) captives bundled with life insurance are energetic, if not virulent, in
their defense of the strategy, but that nobody else has signed on to the idea
is by itself a great big bright waiving red flag.

Maybe time will prove them to be right, and the rest of us to
be wrong. But who wants to be the test case and face the potentially massive
penalties if this strategy crashes?

This is not to suggest that captives that have made the
831(b) election are inherently bad, or that the IRS is looking at such captives
in isolation. There is no evidence of that, and in fact the vast bulk of 831(b)
captives, not involved with life insurance, will qualify as valid captive
arrangements. Nobody expects anything like a general pogrom against 831(b)
captives anytime soon, and the IRS itself has not indicated any interest in
that (as stated above, the tax benefits of 831(b) captives aren’t exactly
earth-shattering when they are used as they are meant to be used as true
risk-management vehicles).

At the very least, one should take a “wait and see” position
in regard to this strategy, keeping in mind that not just a few highly
experienced tax professionals are waiting to see it crash and burn, just like
the VEBAs, 412(i) and 419A(f)(6) plans before it.